Freebasing Your Estate

Recent tax law changes are turning traditional estate planning on its head. Indeed, moves long considered savvy--for example, aggressively shifting wealth to younger generations while senior family members are still alive or leaving assets to a "bypass" trust--may no longer be necessary to save estate tax and could now leave many families paying income tax they wouldn't otherwise owe.

While planners are still working through all the angles, the big rethink was set in motion by the legislative deal Congress passed Jan. 1, 2013. It made permanent the most generous exclusion from estate and gift tax, in real dollars, since the birth of the death tax in 1916 and raised the top income tax rate on long-term capital gains to its highest level since 1997. Including the new 3.8% net investment income tax that took effect last year as a part of ObamaCare, the top rate on long-term capital gains from stocks is now 23.8%, up from 15% in 2012.

At the same time, even many 1 percenters no longer need to worry about the federal estate tax. The Tax Policy Center projects that just 0.14% of adult deaths this year will result in federal estate tax, down from 2.3% in 1999 and 7.65% in 1976. Currently each person can transfer $5.34 million to heirs during life or at death, before a transfer tax of up to 40% kicks in. Not only will that so-called "applicable exclusion" rise with inflation, but spouses can now share--and effectively inherit--each other's exclusions. AllianceBernstein projects that in ten years a couple will be able to pass on a combined $13.16 million and in 20 years $17.9 million--and that whole amount could be used by a widow or widower.

At the recent annual Heckerling Institute (the leading conference for estate pros) Paul S. Lee, a Bernstein wealth manager, called for a new approach to planning he puckishly described as "freebasing"--because it frees survivors to get the most potent income tax savings from the step-up in basis of the deceased's property.

Step-up? When you sell an asset such as stock, you owe capital gains tax on the difference between what you paid for it (your basis) and what you get for it. But if you inherit certain assets you can step up their tax basis to whatever they were worth at your benefactor's death. That means highly appreciated inherited property can be sold immediately with no capital gains, or later, with all the gains before you inherited it disregarded. By contrast, if you receive property from a living donor, you take on his tax basis when the time comes to calculate capital gains. (You can neither inherit nor be given capital losses.)

Step-up isn't new but has now become central to wealth-transfer planning for many families, including some still likely to have taxable estates. Depending on where you and your intended beneficiaries live, "the income tax savings from the step-up in basis may be greater than the transfer tax cost, if any," says Lee.

For example, in California, which has no state estate tax but levies a 13.3% state income tax on income above $1 million, heirs would pay a combined state and federal top rate on gains from the sale of a Rothko that exceeds the top estate tax rate of 40%. But families in Washington State, which has no income tax but levies a top estate tax of 20%, would still find estate tax more onerous. This suggests that Californians "should be much more passive in their estate plans, choosing more often than not to simply die with their assets, than Washington residents," Lee says.

Note that not all assets benefit from the step-up in basis, so factor that into decisions about what, if anything, to give away during life, Lee says. Low-basis stock and intellectual property, such as copyrights, trademarks and patents, all benefit. So do art, gold and collectibles, which are particularly good items to hang on to, since gains on these are taxed at 28% (plus the 3.8% ObamaCare tax and any state tax). Fully depreciated investment real estate is another keeper; if you sell or give it away while you're alive, depreciation you've claimed will be "recaptured" at a 25% rate (plus, again, 3.8% and any state tax).

There's no step-up benefit to leaving your heirs cash or variable annuities, whose payouts are taxed as ordinary income and return of basis. As for pretax IRAs and 401(k)s, while heirs can stretch out withdrawals, thus benefiting from tax deferral, all the dollars they eventually take out will be taxed at high ordinary income tax rates. (See "Inherited IRA Rules: What You Need To Know.")

The new tax landscape also has huge implications for married couples. Widows and widowers can now carry over any unused exclusion of the spouse who died most recently and add it to their own. Portability, as tax geeks call it, doesn't change the fact that you can give an unlimited amount to your spouse, during life or through your estate plan, provided he or she is a U.S. citizen, with no federal or state tax applied. But before portability, if the first spouse to die simply left everything to the survivor through an "I love you" will, the dead spouse's estate tax exclusion was lost. To avoid that problem you had to either leave assets directly, up to your exclusion amount, to someone other than your spouse or set up a special kind of trust known as a bypass or credit-shelter trust. It works like this: At the death of the first spouse an amount up to his exemption goes into a trust for the kids. The surviving spouse has access to the earnings (and in some cases principal) of the trust, but the assets in the trust aren't hers outright and bypass her estate when she dies.

To be sure, you still might want one of these concoctions to protect assets from creditors or assure (in the case of a second marriage) the money goes to your own kids. But otherwise, simply relying on portability often makes more sense, particularly if your assets are comfortably under $10 million and you live in one of the 31 states without its own estate or inheritance tax.

Aside from the hassle factor of a trust, the "tax drag" of having assets in a trust is now greater than before. Assets in a regular bypass trust won't get a step-up in basis at the death of the second spouse. In addition, unless trust income is distributed, the income tax penalty can be huge. That's because a trust hits the highest income tax bracket once it has more than $12,150 of taxable income. In contrast, a single individual doesn't hit this bracket until his taxable income is more than $406,750.

No surprise, lawyers aren't giving up on trusts. Instead they're busy looking for ways to minimize the tax damage from existing trusts and adapt future trusts to avoid expensive income tax consequences. One possibility, for widows and widowers already stuck with bypass trusts, is for the trustee to distribute assets out of the trust (assuming the trust terms allow this) to the surviving spouse, says Thomas W. Abendroth, a lawyer with Schiff Hardin in Chicago.

Another ploy involves living donors who made irrevocable transfers to grantor trusts for their children or grandchildren. All the annual income in these trusts goes on the donor's income tax return, so that's not a problem. But the loss of step-up could be. So in some cases lawyers are suggesting donors shuffle assets, swapping low-basis assets out of their trust (and into their taxable estates) and property that won't benefit from step-up into the trust, Abendroth says. The stated trust powers must allow for this, but typically, with a grantor trust, they do.

These damage control measures keep clients dependent on advisors. That's good for the estate pros' bottom line but bad for cost-conscious consumers who might prefer to revisit estate planning on a more occasional basis--say, when life events dictate.